An Empirical Analysis of the Relationship and Transmission Mechanism Between Inflation and Economic Growth: the Case of Indonesia, 1980-2012

Abstract

Much as economists seem to be in total agreement that high rates of inflation impede economic growth, there isless consensus about the precise relationship between inflation and economic performance, and the mechanismby which inflation affects economic activity at the macroeconomic level. The cardinal aim of this study washenceforth to find out if a meaningful relationship does exist between inflation and economic growth inIndonesias case and to further ascertain the transmission mechanism by which inflation affects economicgrowth. Most of the analyses herein were done using Econometric Views (Eviews7). A stationarity test wascarried out using the Augmented Dickey-Fuller (ADF) test with the aim of finding out the order of integration ofthe individual series under consideration. GDP and CPI which were used as perfect proxies for economicgrowth and inflation respectively were found to be stationary after first difference. The two variables were alsofound to be Cointegrated and upon running Granger Causality tests under VECM environment, a long-rununidirectional causality from economic growth to inflation was detected. On the basis of the impulse responsefunction (IRF) and the long-run Cointegrating equations, it was also found out that inflation and economicgrowth exhibit an inverse relationship both in the short and long-run. All these events showed that a meaningfulrelationship between economic growth and inflation does exist.The results of the transmission mechanism showed that if inflation increases by 1%, the level of investmentdecreases by 0.091680% whereas total factor productivity (TFP) decreases by 0.003295% hence confirmingthe theoretical and empirical literature postulations that the level of investment and TFP indeed serve astransmission channels from inflation to economic growth.Keyword : Inflation, Economic Growth, Indonesia, Cointegration, Granger Causality, Transmissionmechanism, Level of investment, TFP